How is a business valuation calculated?

Calculating the value of a business is normally achieved by using one or more of six commonly used methods.

Which method is applied will depend on the health, maturity and type of business.

Capitalisation of Earnings. This method involves capitalising the earnings of a business at an appropriate multiple reflecting the risks underlying the earnings together with growth prospects.

Net Asset Backing. This is an asset-based methodology. It assumes that the net tangible assets of the business represent the value of the business. Accordingly, it assumes that no tangible assets exist within the business or, if they do, that they have no realisable value.

Industry. The Industry (or Market) method is applied in industry sectors where there are a relatively large number of participants, where the sale of such businesses occurs frequently and the businesses in the sector have reasonably consistent business models.

Cost to Create. This is usually applied when valuing micro (less than 5 employees, for example) businesses, start-up enterprises or businesses with a loss-making history. The method is often applied where there is marginal separation between the return on the labour of the owners and the profits of the business.

Discounted Cash Flow. This approach calculates the value of an entity by adding its future net cash flows to their present value at an appropriate discount rate. It is most usually applied when a business does not have consistent historical earnings but value can be identified due to capacity to generate future earnings.

Dual Valuation Method. When an entity trades as a business enterprise and holds assets and liabilities surplus to the requirements of the business enterprise, it is appropriate to value the entity using a dual methodology. An earnings-based method is used to value the business enterprise and a net asset approach is adopted to value the surplus assets and liabilities.

BIZVAL encourages you to obtain a full appreciation and understanding of all aspects pertaining to a business valuation. The Australian Taxation Office provides excellent information regarding business valuation methodologies.